Copyright © Alberto Manconi 2016–today, all rights reserved.

The material in this reader is made available only for personal use
by the students of my Introduction to Options and Futures course at
Bocconi University. This reader or any portion thereof may not be
distributed, reproduced, or used in any manner whatsoever without
express written permission from the author.
6
Swaps

Swaps are among the most versatile derivative contracts. They

can be used to transform the structure of a firm’s liabilities or invest-
ments, e.g. from fixed to floating rate, or into a different currency.
That makes swaps useful as hedging tools, or to obtain cheaper/more
convenient funding. We will learn how to design and price interest
rate and currency swaps. As we are about to see, plenty of the ba-
sic tools that we learned working with forwards also come in handy
here. There are other kinds of swaps out there; but they are beyond
the scope of an introductory class such as ours (and interest rate and
currency swaps already provide plenty of learning opportunities!)

Note. We base part of the class discussion on this topic on the “Walt
Disney’s Yen Financing” case. For copyright reasons, I cannot write
up a detailed solution to the case here. Therefore, I will provide a
summary of the key learning points, without making direct reference
to the case itself. It goes without saying, you should also study the
case.

Preparation questions

1. How can you use an interest rate swap to hedge a floating–

rate liability?

2. How can you use a currency swap to hedge a foreign

currency–denominated liability?

3. How can you assess the surplus available for a swap?

4. How can you replicate (or hedge) an interest rate (or cur-
rency) swap?

6.1 Basics

A swap is a contract in which two counterparties agree to exchange

cash flows at periodic intervals. It matters that we refer to “cash
36 introduction to options and futures

flows” here: in many cases swaps can be OTC contracts, specifi-

cally designed, say, to match a cash flow stream that we would like
to hedge; but in general, we determine the cash flows that are ex-
changed as interest payments on a certain principal. It also matters
that we refer to “periodic intervals”, for otherwise we would be deal-
ing with forward rate agreements.
Interest rate swaps Swaps come in two main flavors: interest rate and currency swaps.
In an interest rate swap, payments are exchanged that are deter-
mined based on different interest rates. The plain vanilla case is a
fixed–for–floating interest rate swap, in which party A makes pay-
ments at a fixed interest rate, in exchange for receiving floating–rate
payments (typically indexed to LIBOR) from party B.
Currency swaps In a currency swap, payments in two different currencies are ex-
changed. The plain vanilla case is a fixed–for–fixed rate currency
swap, in which party A makes fixed rate payments denominated
in, say, Euros, in exchange for receiving fixed–rate payments in, say,
U.S. dollars from party B.
Market size The market for swaps is a large one. One way to measure it is:
add up the value of the notional principals (i.e. the amount based on
which we compute the interest payments that determine the swap’s
cash flows) involved in all outstanding swap contracts. By this gauge,
as of 2016 the interest rate swap market had a size of $275 Tn ($275
× 1012 ), and the currency swap market of $21 Tn ($21 × 1012 ). The
most popular currencies for swaps are U.S. dollars, Euros, Japanese
Yen, British Pounds, and Swiss Francs.
This is a common approach to measuring the swap market size;
but it can be deceiving. As we are about to see, there is no exchange
of principal between the parties in an interest rate swap. That means
that, at any moment during the life of the swap, the parties’ only
exposure is related to interest payments, which are in general much
smaller than the notional principal. Moreover, payments between the
parties are netted out, further reducing exposure. As a result, using
aggregate notional principal as a measure, say, of the risk related to
interest rate swap exposure can lead to overstating such risk. We
should thus treat such statistics with care — as always: being shown
a statistic does not allow us to switch our brains off.
Swap bank In addition to the two parties undertaking the swap, an interme-
diary is typically also involved in the contract: the swap bank. The
swap bank can act as a broker, or as a dealer. As a broker, the swap
bank is just a match–maker: on behalf of a client, it finds a coun-
terparty willing to enter into a swap with the client. As a dealer,
or market maker, the bank posts swap quotes, and stands ready to
enter into swap contracts at those quotes. In that case, bank is said
to make a market in “plain vanilla” swaps; typically the quotes for
such contracts are expressed as percentage points (paid or received)
against LIBOR.
 swaps 37

6.2 Interest rate swaps

A plain vanilla interest rate swap involves the exchange of payments

on fixed–rate for floating–rate debt. There is no upfront cash ex-
change, nor is there a payment of the principal ex post, and interest
payments are netted (i.e. only one party pays the other on any pay-
ment, or “reset”, date). In the typical case, the floating rate is the
LIBOR; but in general there can be a spread over LIBOR.
The main uses of interest rate swaps are to convert a liability or an Typical uses
investment from fixed to floating rate. This can be part of a hedging
strategy, or as a way to obtain cheaper financing (or both).
To see how to design an interest rate swap, let’s consider the fol-
lowing example. Suppose that both Google and Microsoft neet $10
million to finance an investment with an economic life of 5 years. Be-
cause of factors related to the nature of the investment and the firm’s
operations, Google prefers to have a floating–rate liability. Google Google Microsoft
can borrow at a fixed rate of 10% or a floating rate equal to LIBOR; Fixed 10% 11.25%
Microsoft can borrow at a fixed rate of 11.25% or a floating rate of Floating LIBOR LIBOR + 0.5%

LIBOR + 0.5%, as shown in the table. From these values, we deduce

that Google has a higher credit rating than Microsoft (all the values
in this example are, of course, fictional).
A swap bank acts as an intermediary between Google and Mi-
crosoft, and proposes a swap whose terms are summed up in Fig. 6.1.

10.25% 10.375% Figure 6.1: Illustration of the interest rate

swap designed between Google, Microsoft,
and the bank in our example
Google Swap bank Microsoft

LIBOR LIBOR – 0.125%

10% LIBOR + 0.50%

Google is to borrow from outside investors at a fixed rate of 10%. It

will then enter a swap with the bank, in which it will pay LIBOR, re-
ceiving 10.25%. This is convenient for Google, because as a result of
the swap its net borrowing cost becomes 10% + LIBOR − 10.25% =
LIBOR − 0.25%, i.e. 25 basis points cheaper than Google could obtain
without the swap. Further, note that Google has used the swap to
turn a fixed–rate liability into a floating–rate one, as desired.
In a similar fashion, Microsoft is to borrow from outside investors
at a floating rate of LIBOR + 0.50%. It will then enter into a swap
with the bank, in which it will pay 10.375%, receiving LIBOR –
0.125%. This is convenient for Microsoft, because as a result of the
swap its net borrowing cost becomes LIBOR + 0.50% + 10.375% −
LIBOR – 0.125% = 11%, i.e. 25 basis points cheaper than Microsoft
could obtain without the swap.
Note, finally, that this is convenient for the bank too. Because it
38 introduction to options and futures

receives LIBOR + 10.375% from the two firms, and pays 10.25% +
LIBOR – 0.125%, its net profit from the swap is 25 basis points too.
Over a $10 million principal, that amounts to $25,000 annually.
Spreads, surplus, and swap design Would we always be able to set up a swap as in this example?
That depends on the availability of a surplus that can be split among
the two swap counterparties and the swap bank. How can we as-
sess the surplus? In our example, we can see that Google can bor-
row at 1.25% less than Microsoft at fixed rate, but only 0.50% less at
floating rate. We say, therefore, that Google has a comparative ad-
vantage vis–à–vis Microsoft borrowing at fixed rate. The difference
1.25% − 0.50% = 0.75% is the surplus that the three parties in the
swap (Google, Microsoft, and the swap bank) can split.
In our example, we split it in equal parts, so that each obtained a
25 basis points gain; in general, the way it is split among the parties
will depend on a number of variables, notably bargaining power. If
the surplus equals zero, or if it is negative, we will not be able to
arrange a swap that benefits all parties — that means: we will not be
able to arrange a swap, period. As an exercise, design an alternative
version of the swap between Google, Microsoft, and the swap bank,
with a different distribution of the surplus.
The “comparative advantage” argument (and One interpretation of these facts is as follows. Due to some form of
criticism thereof)
debt market segmentation, some firms have a comparative advantage
borrowing at a fixed rate, and others at a floating rate; that creates
gains from trade, i.e. room for swaps. If this were true, however,
arbitrage activity should sooner or later eliminate the spreads, and
we shouldn’t see such a large market for interest rate swaps.
More likely, the differences in spreads spreads are due to the dif-
ferent nature of fixed and floating rates. In the floating–rate market
rates can be revised, typically every six months, to reflect e.g. in-
creased default risk. Since this is not possible for fixed rates, which
remain fixed for the life of the swap, often stretching over several
years. The risk of default over a long period of time for a lower–rated
company is higher than for a higher–rated company, whereas over a
shorter horizon their default risk might be similar; for that reason,
fixed–rate spreads are typically larger than floating–rate ones.

6.3 Valuation of interest rate swaps

The next step is valuing interest rate swaps. As always, we are going
to apply no–arbitrage reasoning. As we have seen in the case of
forwards (and foreign exchange futures, and FRAs, and as we will
see for options), that reasoning can take the form of a “replicating
portfolio” approach, or a “hedging portfolio” approach. In the case
of swaps, we will use both.
Just like a forward, we know that at inception the swap must have
a value of exactly zero; otherwise, one of the parties involved would
refuse to enter the contract. The problem then is valuing the swap
some time after inception.
Approach 1: Replicating portfolio A first approach is to note that an interest rate swap is equivalent
 swaps 39

to a long position in a floating rate bond plus a short position in a

fixed rate bond (or vice versa, depending on whether we take the
point of view of the fixed rate payer or receiver). Thus, to value
the swap, we just need to price the two bonds. Pricing the fixed rate
bond is straightforward: compute the present value of all future cash
flows.
Pricing the floating rate bond may seem challenging, because we
don’t yet know all the coupons that will be received in the future.
In fact, we can proceed as follows. Suppose that you are valuing
the swap at some point in time t̃ between reset dates tn and tn+1 .
On reset date tn , the reference rate, say LIBOR, was observed, and
determined an interest payment k∗ , which will be paid on reset date
t n +1 .

t n −1 tn t̃ t n +1
t

L
n
rm res

io

×
at

k∗
ed
te

lu
in

in

pa est
Va
ng

r
k ∗ ati

te
te

id
In
de
o
Fl

is

is

So, at the next reset date tn+1 , the floating rate receiver in the
swap receives k∗ . In addition, she also receives a claim to all fu-
ture payments on the floating leg of the swap. What is the value of
it? Observe that, since on date tn+1 the floating rate is reset based
on the rates prevailing in the market, she receives a bond paying
coupons tied to LIBOR; and that to value the bond, we should dis-
count these coupons at the LIBOR rate. That means: the bond she
receives must be trading at par. Denoting by L the swap’s notional
principal, therefore, the floating rate receives obtains L + k∗ at reset
date tn+1 . The value of this amount at some prior date t̃ is then
( L + k∗ ) exp{−rn+1 (tn+1 − t̃)}, where rn+1 is the zero rate associated
with reset date tn+1 .
Let’s make this more concrete with an example. Suppose we Example
are valuing a fixed–for–floating interest rate swap for 8% against
6–month LIBOR, with notional principal $100 million. The swap
makes semi–annual payments, and has a residual life of 1.25 years.
On the last reset date, the LIBOR rate was 10.2%. The term struc- Maturity Rate
ture of LIBOR rates is as reported in the table. As a first step, let’s 3 months 10.0%
compute the value of the fixed rate leg. Because the swap makes 9 months 10.5%
15 months 11.0%
semi–annual payments, at each reset date the fixed payments are
2 × 8% × $100 million = $4 million. The present value of the fixed
1

rate leg is therefore:

B f ix = 4e−0.25×10.0% + 4e−0.75×10.5% + 104e−1.25×11.0%

= $98.238 million

Note that on the final reset date the principal payment takes place
too. Next, the floating rate leg. Because LIBOR was 10.2% on the last
reset date, on the next reset date the floating rate leg pays a coupon
40 introduction to options and futures

1
2 × 10.2% × $100 million = $5.1 million. In addition, the claim on
the residual floating rate payments is a par bond, i.e. its value is
precisely $100 million. The present value of the total claims on the
floating rate leg is thus:

B f loat = (100 + 5.1) exp {−0.25 × 10%}

= $102.505 million
The value of the swap, from the point of view of the floating rate
payer, is thus: V = B f ix − B f loat = $98.238 million − $102.505 million,
or −$4.267 million.
Approach 2: Hedging portfolio It turns out we can reach the same result with a hedging portfolio
approach, as follows. Suppose you are the floating–rate payer in an
interest rate swap. At any point in time t̃, the payment you will make
on the upcoming reset date tn+1 is known; the one you face on reset
date tn+2 , however, is unknown. You are therefore exposed to the
risk that interest rates rise. How can we hedge?
We are already familiar with one derivative instrument designed
to hedge interest rate risk: forward rate agreements. So, we can enter
an FRA to hedge interest rate risk for reset date tn+2 . We can make
the same argument about tn+3 , tn+4 , etc., entering one FRA for each
of them. Therefore: A portfolio of FRAs hedges the risk borne by
the floating–rate payer in the interest rate swap. By our familiar no
arbitrage logic, the value of the interest rate swap is then equal to the
value of the hedging portfolio of FRAs.
Example As an illustration, let us go back to our earlier example; and as-
sume, for the sake of the example, semiannual compounding through-
out. The “recipe” to value an FRA is: assume that future spot rates
will be equal to today’s forward rates, and discount. So the first step
is obtaining forward rates. The forward rate for the period from 3 to
9 months from now is:
0.75 × 10.5% − 0.25 × 10.0%
F3,9 = = 10.75%
0.5
That is a forward rate based on continuous compounding. Passing to
semiannual compounding, the implied FRA rate is 2(e10.75%/2 − 1) =
11.04%. This implies a floating rate payment on the reset date 9
months from now of $100 million × (11.04%/2) = $5.100 million.
Similarly, the FRA rate for the period from 9 to 15 months from now
is 12.10%, implying a floating rate payment 15 months from now of
$5.522 million. The payment 3 months from now has already been
determined at $5.100 million. Taking present values and adding up
the payments, the value of the floating rate leg is $15.351 million.
Subtracting this from the value of the fixed rate let of $11.084 million,
the value of the swap is −$4.267 million, just as before (as it should
be).

6.4 Currency swaps

A plain vanilla currency swap is fixed–for–fixed, i.e. it involves the

exchange of payments at fixed rates, denominated in different cur-
 swaps 41

rencies. Unlike the case of interest rate swaps, in a currency swap

the principals are exchanged, first at the inception of the swap, then
at the end of the swap. In between, fixed interest payments are ex-
changed. Typically, currency swaps are used to convert a liability or
an investment from currency into another.
To see how to design a currency swap, let’s consider the following
example. Suppose that IBM (a U.S. company) and BP (a U.K. com- IBM BP
pany) need to finance investments of comparable size in each other’s $ 8.0% 10.0%
countries. The spot exchange rate is S0 ($/£) = $1.60/£; IBM needs £ 11.6% 12.0%

funding for £10 million, and BP needs $16 million. The two compa-
nies’ borrowing costs are as described in the table (this example is
fictional).
To understand whether there is a surplus that the companies can Surplus
split, suggesting benefits from a swap, in one example your textbook
simply takes the difference in spreads, similar to what we did in the
case of interest rate swaps. In most examples that we come across,
that approach will deliver the correct intuition. However, it does
seem surprising to subtract a British pound spread from a U.S. dollar
one; after all, those rates refer to different currencies.
In our class discussion, we considered an alternative way to assess
the spread. In the terms of our example, look at the total interest pay-
ments of IBM plus BP, first assuming that BP borrows in dollars, and
then assuming that BP borrows in pounds. Even though in absolute
terms BP’s dollar rate is lower than its pound rate, aggregate inter-
est payments are lower if BP borrows pounds. The swap, thus, can
benefit the two firms: the difference in total interest payments is the
surplus they can split.

$8.0% $9.4% Figure 6.2: Illustration of the currency swap

designed between IBM, BP, and the bank in
our example
IBM Swap bank BP

£11.0% £12.0%

$8.0% £12.0%

A swap bank can arrange the swap terms as illustrated in Fig. 6.2.
IBM is to borrow from outside investors at a fixed U.S. dollar rate of
8.0%. It will then enter a swap with the bank, in which it will pay
£11.0%, receiving $8.0%. This is convenient for IBM, because as a
result of the swap its net borrowing cost becomes $8.0% + £11.0% −
$8.0% = £11.0%, i.e. £60 basis points cheaper than IBM could obtain
without the swap. Further, note that IBM has used the swap to turn
a U.S. dollar liability into a British pound one, as desired.
In a similar fashion, BP is to borrow from outside investors at
a fixed British pound rate of 12.0%. It will then enter into a swap
with the bank, in which it will pay $9.4%, receiving £12.0%. This is
42 introduction to options and futures

convenient for BP, because as a result of the swap its net borrowing
cost becomes £12.0% + $9.4% − £12.0% = $9.4%, i.e. $60 basis points
cheaper than BP could obtain without the swap. As for IBM, BP has
turned a British pound liability into a U.S. dollar one.
What’s in it for the bank? Because it receives $9.4% − $8.0% =
$1.4% on the U.S. dollar side (on $16 million), and pays £12.0% −
£11.0% = £1.0% on the British pound side (on £10 million), its net
exposure to the swap, at the current exchange rate of $1.60/£, is
$64,000. Put differently: the bank is long U.S. dollars, and short
British pounds. The bank can easily hedge this exposure, e.g. with
currency forwards.

6.5 Valuation of currency swaps

We can value currency swaps in ways that are similar to interest rate
Approach 1: Replicating portfolio swaps. As before, we can view the swap as a portfolio of two bonds,
denominated in different currencies. Denoting by D the “domestic”
currency and F the “foreign” one (the names are just placeholders;
they can really be any two currencies), the value of the swap, from
the point of view of the domestic currency receiver, is then:

VSwap = BD − S0 ( D/F ) BF

where S0 ( D/F ) is the spot exchange rate at the time we make the
valuation. Clearly, the terms in the above expression are reversed if
we take the perspective of the “domestic” currency payer.
Example For instance, suppose that the term structure is flat in the U.S. and
in Japan, at r¥ = 4% and r$ = 9% with continuous compounding.
You would like to value a swap in which you are to receive ¥5% and
pay $8%, once a year. The notional principals are ¥1,200 million and
$10 million; the remaining life of the swap is 3 years, and the spot
exchange rate is S0 (¥/$) = ¥110/$.
The payments on the Yen bond are ¥60 each year. Combined with
the principal payment of ¥1,200 at maturity, their present value is
 
B¥ = ¥60 × e−5%×1 + e−5%×2 + e−5%×3 + ¥1, 200e−5%×3 = ¥1, 230.55.
Similarly, the present value of the U.S. dollar bond is B$ = $0.80 ×
(e−9%×1 + e−9%×2 + e−9%×3 ) + $10e−9%×3 = $9.64. Therefore, the
value of the swap to you is S0 (¥/$) × B¥ − B$ = ($0.0091/¥) ×
¥1, 230.55 − $9.64 = $1.54 million.
Approach 2: Hedging portfolio An alternative approach is to note that a position in the swap can
be hedged by a portfolio of currency forwards; thus the swap’s value
is equal to that of the hedging portfolio. Put differently: Assume that
forward (exchange) rates are realized in the future, and discount.
Example Going back to our example, we need to compute forward ex-
change rates using the familiar expression F = S0 e(r−r f )T . Simple
calculations yield F1 = $0.0096/¥, F2 = $0.0100/¥, F3 = $0.0106/¥.
The implied net swap cash flows (Yen inflows minus U.S. dollar out-
flows) are –$0.23, –$0.20, and $2.51 million; in present value terms,
again a $1.54 million value for the swap.
 swaps 43

6.6 Credit risk in swaps

If you look back at the swaps described in Fig. 6.1 and 6.2, you realize
that the swap bank is hedged as long as both parties in the swap are
solvent. This is, by the way, the reason why banks can afford making
a market in plain vanilla swaps: they bear little risk, as long as fixed
and floating rate sides are approximately evenly balanced.
Suppose, however, that Microsoft defaults in the example of Fig. 6.1.
If at that time the swap has a positive value for the bank, the bank
bears a loss corresponding to the swap value. Does that mean that
if the swap has a negative value for the bank and Microsoft defaults,
the bank makes a gain? Not necessarily. More likely, Microsoft will
try to preserve the positive value of the swap in some way (e.g. sell
its contract to a third party); thus the bank simply does not make a
loss.

Case study

Kester, W.C. 1996. The Walt Disney Company’s Yen Financing.

HBS Case 287–058.